Oil rise a mixed blessing for bonds?

Bond market stays focused on economic soft spots

KateGibson

CHICAGO (CBS.MW) - In theory, the soaring price of oil could be a double-edged sword for the Treasury market, with positive as well as negative implications for the value of fixed-income debt.

In practice, at least in recent weeks, bonds have rallied along with crude futures, driving yields on the benchmark 10-year note to a more than four-month low 4.15 percent from 4.65 percent less than a month ago.

"I think consumer and business spending has slowed because of oil prices," said MaryAnn Hurley, a bond analyst for D.A. Davidson. "It's a negative for the economy, which is positive for Treasurys."

"Bonds have been rallying going on two months now, pretty much across the curve (amid) a focus on the economically restrictive effects of higher oil prices," said Scott Pedowitz, a fixed-income strategist at Commerzbank Securities.

High oil prices are generally viewed as inflationary, a scenario that could chip away at the value of Treasurys. Escalating inflation could also prompt more aggressive Federal Reserve interest-rate hikes, which are also unwelcome by bond investors.

However, "the measure of inflation that the Fed is targeting is the core personal consumption deflator, which excludes food and energy," says Hurley, who argues the situation as it stands does not call for a steady pace of Fed moves.

"If these high oil prices remain, it is hard for me to believe the Fed is going to risk further damage to the economy by raising interest rates further," said Hurley. "If the economy is on firmer footing, I think they will raise rates at their Sept. 21 meeting. If the economy is showing further signs of struggling here, they have reason to wait."

"Higher oil prices make the Fed's job more difficult by both raising inflation and depressing output. In most circumstances, an oil-price shock should result in higher, not lower, interest rates," said Bill Dudley, analyst with Goldman Sachs.

"I'm leaning to them moving in September," said Pedowitz, who believes the central bank will lift its current 1.5 percent target rate a quarter-point at two of its three remaining meetings this year. "I'm inclined to get to 2 percent and then pause, but there is still a lot of data between now and then," Pedowitz said.

The present situation poses a dilemma for monetary authorities. Should they "ease policy to support real output or tighten to resist inflation?" asks Dudley.

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